Don't get too excited about the bull market

(MoneyWatch) Investors seem to be embracing the bull market we've experienced in the past few years, putting large assets into stocks. However, they must remember not to get caught up in the recent market returns and instead stick to their plans.

The bear market that began in October 2007 and ended in March of 2009 caused many investors to abandon even well-developed plans and pull hundreds of billions of dollars out of stock mutual funds. They ended up missing out on a rally of more than 130 percent, based on the S&P 500 Index.

Now, fund flows have reversed course, and the spigots appear to be open full blast. Lipper reports that stock funds had net inflows of $27 billion in February and stock ETFs had net inflows of an additional $25 billion. The trend continued in March. Through March 27, stock funds reported inflows of about $20 billion and stock ETFs of another $12 billion.

Readers of my blog know that I don't believe in making forecasts and that one of the keys to being a successful investor is to have the discipline to adhere to a well-developed plan through both good and bad times, rebalancing along the way. So today's blog post is a reminder to not let the current bull market to cause you to become complacent about risk and lose discipline.

Disciplined investors benefited from the bull market of the 1990s, selling stocks (high) by rebalancing according to their plans. Thus, they were much better prepared for the bear market that lasted from 2000 through 2002 than if they hadn't rebalanced.

Those investors who didn't panic and sell, but instead continued to rebalance, were buying stocks (at now much lower prices). The bull market from 2003 through 2007 once again gave disciplined investors the opportunity to sell high, positioning themselves much better for the bear market that ensued. That bear market once again gave them the opportunity to buy low. The past two years have once again presented them with the opportunity to sell high.

Investing is really that simple. The problem is that it isn't easy to buy low and sell high. In fact, investors exhibit a strong tendency to do the opposite: They "chase" returns, which leads to them buying high and selling low.

The winning strategy is quite simple:

  • Write an IPS tailored to your unique ability, willingness and need to take risk
  • Only alter the plan if the assumptions upon which it's based have changed
  • Use passively managed funds to build a globally diversified portfolio
  • Regularly rebalance and tax manage as appropriate
  • Ignore all "guru" forecasts and the noise of the market

That's about it. Simple. Unfortunately, it isn't easy because emotions get in the way. In bull markets, like the one we have experienced since March 9, 2009, greed and envy take over and investors lose discipline and begin to take on more risk. They forget the lessons of the past and "run with the herd." In bear markets, it's fear and panic that take over, and the stomach overrules the head. Stomachs rarely make good decisions.

While we have been lucky to have experienced the greatest bull market since the Great Depression, it's important not to lose sight of the fact that there are only three things we don't know about bear markets:

  • When they will start
  • How deep they will be
  • How long they will last

I'm certainly not forecasting a bear market. However, I'm reminding you to stay disciplined. Investing in equities is always risky, no matter how long your horizon. And the risks can appear from totally unexpected, and thus unforecastable, sources. The recent series of revolutions in the Middle East, along with the earthquake, tsunami and nuclear disaster that hit Japan, are good reminders of that, as are the September 11 attacks. Don't let the recent bull market allow you to become complacent. Make sure your IPS is current (check to see if any of the assumptions have changed) and stay disciplined. That will give you the best chance of achieving your goals.

Image courtesy of Flickr user Lee J Haywood